Eckart Woertz: Gulf should follow China into real assets, gold

Revisit Investment Strategist

By Eckart Woertz
Financial Times, London
Wednesday, July 22, 2009

http://www.ft.com/cms/s/0/bf3e8d46-76cd-11de-b23c-00144feabdc0.html?

Last week's visit by Tim Geithner, US Treasury secretary, to Jeddah and Abu Dhabi highlighted the importance of Arab Gulf countries to the United States. The six countries of the Gulf Co-operation Council have come to rival China when it comes to financing the US current account deficit.

However, this year two changes to the status quo have emerged: first, Gulf countries are likely to have much reduced surpluses and less money to spend; and second, by dint of printing money, the Fed has emerged as a third major customer for US securities alongside oil exporters and Asian manufacturers.

This policy of quantitative easing has raised concerns on the part of US creditors about the quality of their assets.

At current oil price levels new large scale purchases of US securities by Gulf countries cannot be expected. With the possible exception of the UAE and Qatar, and assuming oil prices average around $50 over 2009, the Gulf states will run budget deficits this year. The Saudi Arabian Monetary Agency has already withdrawn $50 billion of its foreign assets as the government has financed a stimulus package.

Thus, Mr Geithner cannot expect a lot of new money from this source this year. That said, the Gulf countries are still major holders of dollar assets and it is important to keep them on board because the dollar will weaken substantially should they decide to sell even part of their holdings. And, if oil prices recover over the coming years as the International Energy Agency expects, the surpluses will return and Gulf countries will again be customers of the US Treasury.

Mr Geithner assured Gulf investors that the US is committed to a strong dollar and that the US economy is open to direct investment. He intimated that a second Dubai Ports World will not happen. His hosts vowed to stick to their dollar pegs.

However, the Gulf countries may have reason to think again. The strong dollar policy was never much more than rhetoric. Experts felt hard-pressed to find a definition for it while living through one of the largest debt binges in history.

Now debt is also supposed to be the cure. Mr Geithner's assurances in Jeddah that "we are very committed to make sure that, as we get through this crisis, to bring down our fiscal deficits" is reminiscent of a notorious drinker promising to give up the bottle tomorrow.

Adam Smith once said that "when national debts have ... accumulated to a certain degree" they lead either to bankruptcy or to the making of a "pretended payment." Quantitative easing and a budget deficit of over 12 per cent of gross domestic product are likely to lead to the latter and creditors of the US are starting to worry.

China has called for an alternative international reserve currency in the form of the IMF's special drawing rights. Russia has suggested making gold part of the currency basket that defines the value of the SDRs.

Compared to China, which holds about 70 per cent of its currency reserves in dollars, the Gulf countries have a larger degree of diversification via their sovereign wealth funds’ investments -- but they are also more vulnerable to dollar weakness.

Dollar accumulation in China is ultimately a function of an export-led growth strategy and an undervalued exchange rate. Should the dollar devalue sharply China will at least have the capital stock -- plant and machinery -- it has built up with this strategy.

The Gulf states will have less, having largely traded oil for paper. Capital preservation and risk adjusted returns are more important for them than for Asian investors.

The Gulf countries will need to reconsider their investment allocations along three broad guidelines as currency markets face a prolonged period of readjustment.

First, they should buy real assets as the Chinese have done and build up strategic industries.

Second, they should engage in cautious currency diversification with gold being the ultimate dollar hedge.

Third, they should engage in a reform of the international financial system and seek more influence in a reformed IMF against provision of capital injections.

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Eckart Woertz is programme manager, economics, Gulf Research Centre, Dubai.

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